U.S. Tax Court Finds Architectural Design Firm Performed Qualified Research Under Fixed-Fee Contracts
Summary
Summary judgement was granted to a taxpayer in a December tax court case (Populous Holdings Inc. v Commissioner of Internal Revenue Service) hinging on whether its research was funded and thus ineligible for the research and development (R&D) credit. The case clarifies how the court analyzes contract terms to determine whether a project is funded for the purpose of the credit.
Detail
An architectural design firm, Populous Holdings, Inc. (Populous or taxpayer), claimed federal research credits related to its architectural design services in 2010 and 2011. The IRS contended that the taxpayer was ineligible for the credits, as payment for the services was not contingent on the success of the research and the taxpayer did not retain substantial rights to the research.
The Internal Revenue Code disallows expenses related to “research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).”[1] When taxpayers perform research on behalf of third parties, expenses can be qualified research expenses if the taxpayer “retains substantial rights in the research” and if the expenses are “paid or incurred pursuant to an agreement that requires the taxpayer to bear the expense even if the research is not successful.”[2]
In the finding for Populous, the court first discussed the payment terms for the services provided. In determining who “bears the expense even if the research is not successful,” the court emphasized that the financial risk of the research’s failure, not the project’s failure, was at issue.[3] The court noted that none of the projects analyzed explicitly required research or noted that the taxpayer was being paid for research, rather the taxpayer “is paid for a work product at a fixed price.”[4] The court did not consider hypotheticals related to the eventual architecture succeeding or failing, as the design itself (the “work product”) was the business component requiring research. As the contract was a fixed price, the taxpayer was at financial risk of incurring additional expenses without additional compensation if the work product was not successful. Clients of the taxpayer also had a contractual right to review and approve design documents. Some contracts even required the taxpayer to make certain design revisions without additional compensation, although some also stipulated that particular additional services were to be compensated at a set hourly rate. Clients were additionally granted rights to dispute invoices. Taken together, the court found that the fixed price contracts for architectural design services did leave the taxpayer with the economic risk of failed research.
The court next considered whether the taxpayer also retained substantial rights to the research created. The IRS argued that because ownership of the documents created as the work product was transferred to customers, Populous did not retain substantial rights to the research. The court found that despite the taxpayer’s customers receiving rights to project-related documents and architectural copyrights, and despite contractual prohibitions on the taxpayer’s use of “distinctive original, material exterior features” without customer consent, Populous yet retained substantial rights to use the research results. The court noted that “ownership of documents does not dictate the right to use technology-related research… There is no provision in the contracts that prohibits petitioner from using the related researched technology in its business.”[5] Furthermore, there was no contractual provision requiring Populous to pay fees of any kind to use the results of the research it conducted.
Not analyzed in the case, but of interest to many taxpayers and tax practitioners, is the qualification of architectural design as a permitted purpose. As the court granted summary judgement in favor of the taxpayer related to the question of whether the research was funded or unfunded, the court did not consider the acceptability of architectural documents or “work product” as a business component, and thus did not consider the qualification of activities to produce such documents as R&D for the credit. While the case does not create useful precedent for qualifying architectural design efforts as R&D for the purpose of the credit, the fact that the IRS hinged its argument on funding rather than arguing the taxpayer did not perform qualified research provides some support for the inclusion of expenses related to these efforts.
BDO Insights
Populous provides a valuable precedent for taxpayers claiming research expenses related to work performed on behalf of third parties, including architectural and other design firms working on contract. Where contract prices are fixed and do not mention research, the court is likely to find that the economic risk of failure remains with the contract researcher. The court’s decision is also taxpayer-friendly as related to substantial rights, as the transfer of ownership of the documents created during research to the customer did not preclude the taxpayer from claiming substantial rights to use the technology-related research results. Taxpayers should reanalyze their contracts in light of this decision to determine whether research performed on behalf of third parties or performed on the taxpayer’s behalf by third parties may in fact be qualified for the R&D credit.
SHARE